Funds are flowing out of US govt bonds into emerging markets

A file photo of the Bombay stock exchange. Indian equity markets have seen record foreign institutional inflows of over $3.01 billion in January. Photo: Mint

Updated: Mon, Jan 28 2013. 08 35 PM IST

Funds may continue to pour into emerging markets as investors exit from US government bonds and seek out high-risk equity assets for protection against inflation. The Indian markets as well as emerging market equities have been rallying while US bonds prices have fallen 2% in the past one month.

“Cumulative outflows from US bonds since the beginning of December stand at $5.25 billion, though the broader trend of outflows started late in the second quarter of 2012,” Cameron Brandt, senior global market analyst at EPFR Global, said.

Flows into emerging market equities took off following the third round of quantitative easing in the US and the announcement by the European Central Bank in September to buy a vast amount of government bonds to spur the flagging economy.

“Investors have only committed a net $122 million to dedicated India Funds since the beginning of fourth quarter of 2012,” Brandt said. “But they have committed some $30 billion during the same period to Global Emerging Markets Equity Funds, which on average allocate 6-12% of any new money to India. So net flows from all the equity funds we track to India since October exceed $2.7 billion.”

It is not surprising that in January alone, Indian equity markets have seen record foreign institutional inflows of more than $3.01 billion.

It is clear that investors are moving out of US treasuries, which have been seen as a safe haven asset, on expectations that the Federal Reserve’s inflationary policies would weigh on the bond markets, following slightly hawkish comments by chairman Ben Bernanke in the beginning of this year. Bernanke said that the Fed might end the bond buying programme some time this year.

In early 2012, it was institutional redemption that drove outflows from US government bond funds, but since July retail investors have been consistently pulling money out of these funds, according to EPFR Global.

Gary Dugan, chief investment officer for Asia and Middle East at RBS Wealth Division, said, “In the last three years, mutual fund investors have poured around $1.5 trillion into bonds, while they have removed $350 billion from equities.”

This trend is expected to reverse in 2013, and there are already seeing early signs of this. US 10-year bond yields have risen from a low of 1.58% in November to a high of 1.82% in the past week.

Dugan said, “Bond yields in the United States should be around 4% under normal market conditions, which means bond prices will fall further and investors may lose around 10-15% of their capital.”

RBS Private Banking, in a note, said, “Make no mistake, current Fed policies are no longer designed to protect against inflation—they are designed to spur it.”

What does this mean for India?

Saurabh Mukherjea, head of equities at Ambit Capital Pvt. Ltd, said, “Investors are switching out of low-risk government treasuries to high-risk assets such as equities. Around a third of money that enters into emerging markets as investors exit US may find its way into India.”

What’s the risk? These fund flows could reverse any time if the government veers away from the reform process and adopts a populist policy ahead of the elections next year as it may weigh on the fiscal deficit.